Variable geometry and the choice of default within the eurozone or Grexit revisited

I am hoping to move away from Greece with this post that sums up my view on the situation. I have always believed Greece would eventually have to exit the eurozone due to the economic strictures imposed upon it. However, until the coming to power of Syriza and the latest crisis, I believed this would occur as a result of a mutual agreement in a controled fashion. Now however, I see an uncontrolled Grexit as the base case and believe this will have negative consequences for Europe. Thoughts below

The big picture is the one I presented at the beginning of last week in which Greek capitulation puts nationalism centre stage in Europe. And I think this is so because of the deficit of democracy we have seen on display during this tail end of the Greek crisis. French President Francois Hollande is trying to repair the damage, calling for the creation of a euro zone government. But time is of the essence if his gambit is to succeed as the forces on display in Greece will put the European Project in a negative light for many months to come. Eventually, this could lead to a splintering of Europe.

But let’s back up here for a moment and look at why this has come to a head. On the one hand, you have those in Europe who believe that Europe can function as a transfer union, a United States of Europe that involves permanent transfers between regions like the ones we see in the UK between the South East and Scotland, in the US between the Northeast and the southeast or in Germany between the west and the former east. Now, we already have a transfer union of sorts via the European structural and investment funds. But we are talking about transfers of a much greater magnitude as evidenced by what has occurred with Greece.

On the other hand, you have others in Europe who believe a transfer union is not acceptable and that the easiest way to prevent this type of arrangement is by setting up a two-speed Europe, the so-called “variable geometry” idea touted by Wolfgang Schäuble. In this version of the European Project, there would be a core group of countries that have compatible economic philosophies and harmonized internal markets which would band more tightly together. They would have a supranational government and Eurobonds, common banking supervision and deposit guarantee schemes – the whole she-bang. But then there would be a second group of countries which were less integrated because their inclusion would necessitate both permanent fiscal transfers and endless bickering over economic policy issues.

Frankly, the second idea sounds more practical and sustainable. It essentially calls for a rump euro, something I have argued in the past makes sense. As the eurozone is presently constituted, we are talking about Germany, Netherlands, Luxembourg, Austria, the Baltics, Finland and Slovakia. But is this idea politically viable? I would say no. First, you can’t have a rump euro without France. And if you had one with France, you can’t have one without Belgium or Italy, founding members of the EU and signers of the 1957 Treaty of Rome. See, getting from here to there will be a struggle. We see that with Greece, where the electorate still strongly wants to be a part of the euro despite the economic hardship they have been through these past seven years. So while a variable geometry or two-speed Europe makes sense, the existing institutional structures and political arrangements make this difficult.

Wolfgang Schäuble is not deterred by these details, however. Here’s my view on Schäuble. He is generally “pro-European”, a federalist who wants tighter integration over time. But he recognizes vast differences across Europe’s economies. And consequently, Schäuble believes that the eurozone as presently constructed won’t ever work because its constituent parts won’t converge – it will be a permanent transfer union, something that is politically unacceptable in Germany, especially after the experience of reunification. Therefore, Schäuble has to resort to a tactical game to get the variable geometry arrangement he wants. Schäuble knows that the Greeks want in the euro and, therefore, won’t leave voluntarily. So Schäuble believes you must force Greece brutally to toe the line of present German economic orthodoxy or be ejected – hopefully by choice, but by force if necessary. This is why the bailout terms have been so onerous.

Now Schäuble is not alone in his thinking. There are many others in the potential rump euro states who share his views – both on the variable geometry idea and the tactics needed to achieve it. Look at former Polish Prime Minister and present EU President Donald Tusk, for example. He gave an interview with the Financial Times that is very illuminating regarding the thinking inside the EU. Tusk is one who doesn’t like Schäuble’s tactical game because he sees the potential for nationalism and the disintegration of Europe. But Tusk agrees with the goals. Here are some of the more noteworthy passages:

“It was one of my main aims in these negotiations, to avoid this risk that someone is a loser and someone is a winner, especially because as you noticed, for sure, the discussion during this economic negotiation was also about things like dignity, humiliation, trust. From history, we know very well that we can’t ignore such values, or such feelings or emotions like dignity, humiliation and trust, especially when we go back to German history. The discussion about dignity and humiliation could recall the most dangerous time in Europe, and this is why I think it’s very important to avoid this dimension in discussions and in negotiation because for sure what we needed was to have no losers and no winners in this context.”

“I am really afraid of this ideological or political contagion, not financial contagion, of this Greek crisis. Today’s situation in Greece, including he result of the referendum and the result of the last general election, but also this atmosphere, this mood in some comments – we have something like a new, huge public debate in Europe. Everything is about new ideologies. In fact, it’s nothing new. It’s something like an economic and ideological illusion, that we have a chance to build some alternative to this traditional European economic system. It’s not only a Greek phenomenon. This new intellectual mood, my intuition is it’s risky for Europe. Especially this radical leftist illusion that you can build some alternative to this traditional European vision of the economy. I have no doubt frugality is an absolutely fundamental value and a reason why Europe is the most prosperous part of the world…. My fear is this ideological contagion is more risky than this financial one.”

“For me, the atmosphere is a little similar to the time after 1968 in Europe. I can feel, maybe not a revolutionary mood, but something like widespread impatience. When impatience becomes not an individual but a social experience of feeling, this is the introduction for revolutions. I think some circumstances are also similar to 1968. The most impressive for me was this tactical alliance between radical leftists and radical rightists, and not only in the European Parliament…. The discussion about Greece, it means a discussion against austerity, a discussion against European tradition, anti-German in some part. Everything was provoking enthusiasm on both sides. It was quite symbolic. It was always the same game before the biggest tragedies in our European history, this tactical alliance between radicals from all sides. Today, for sure, we can observe the same political phenomenon.”

“If I look for something inspiring when it comes to the economy, I am ready to look towards something wise and responsible in different sources than this kind of debate. For me, maybe the best school of thinking is the so-called “ordoliberals” in Germany, in this critical time after the Second World War. Very pragmatic, no ideology, no illusions. Books and also practical politics from [Ludwig] Erhard, [Walter] Eucken, [Wilhelm] Röpke. This, for me, is the source of thoughts that can be very useful for today. Wilhelm Röpke thought – and I think it’s very relevant here today – we have too much Rousseau and Voltaire and not enough Montesquieu.”

To sum up Tusk’s commentary, I would say he looks at ‘nationalism’ as neither right nor left but as anti-European and threatening to the ‘accepted and acceptable’ economic orthodoxy, what he calls “ordoliberalism”. And so his goal is to prevent tactics like Schäuble’s from creating a nationalism that destroys Europe so that Europe can flourish in a new cross-continent ordoliberal economic model. This idea will only work if certain parts of Europe are able to go through wrenching adjustments – perhaps as Poland and Eastern Europe did after the Soviet Union. Otherwise, you are left with Schäuble’s idea or the atomization of Europe as nationalism takes over.

As for Greece, this is the test bed for these ideas because it is the country that has deviated most from the desired ordoliberal economic framework. The question, therefore, is whether Greece represents a longer-term systemic issue or whether it can be excised without impacting the others, as Schäuble contends.

As to default versus Grexit, there are three major scenarios here. The first, my prior base case, is one in which Greece defaults within the eurozone, stays in over the short-term but finds itself in a permanent depression, making a mutual and planned departure over the longer-term. The second is where Greece defaults within the eurozone and stays in the eurozone for the long-term, making the wrenching adjustments necessary to maintain membership in a currency union with Germany. We’ll call this the Tusk scenario. The third is where Greece tries to make the grade under harsh austerity conditions and major economic reforms but is unsuccessful and exits the eurozone in an uncontrolled and messy way. This is the Schäuble scenario, my new base case. And with the Schäuble scenario, the principal question is whether Greece’s exit causes the European Project to eventually break down entirely or whether a variable geometry approach develops without major untoward consequences.

I am not going to attempt to divine the outcome here. I do think that it will be a difficult process however it turns out. In the near-term, expect Greece’s program to fail and for more crisis-related events there to surface in the coming months.

Edward Harrison is the founder of Credit Writedowns and a former career diplomat, investment banker and technology executive with over twenty five years of business experience. He has also been a regular economic and financial commentator in print and on television for the past decade. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College.